Fallback provisions as safety net
IBOR Reform in Switzerland, Part IV
The Swiss Average Rate Overnight (SARON) is expected to replace CHF LIBOR by the end of 2021. The transition to this new reference rate includes debates concerning the alternative methodologies for compounding SARON. This article addresses the challenges associated with the fallback provisions.
In our previous article, the alternatives for a calculating compounded SARON are assessed and an empirical exercise on the differences among the compounded techniques is provided. Moreover, the view of the Swiss NWG is discussed and an example of client pricing of SARON-based mortgages is illustrated. One of the challenges in the transition to SARON, relates to the continuity of existing LIBOR-based contracts with maturities beyond December 2021. This article assesses the challenges of fallback languages.
Fallback provisions as safety net for contracts maturing beyond 2021
After explaining in the previous article the alternative for a calculating compounded SARON and the view of the Swiss National Working Group (NWG), the fallback provisions as safety net for LIBOR-based contracts with maturity beyond 2021 are assessed.
Existing LIBOR-based contracts with maturities beyond December 2021 need fallback provisions, due to the discontinuation (cessation) of the LIBOR rates after 2021. Robust fallbacks must be adopted to reduce the risk of serious market disruption and market participants finding themselves in disagreement or dispute on rights and obligations attached to these LIBOR-based contracts. Furthermore, fallback provisions ensure contract continuity and enable the conversion of contracts at the time LIBOR ceases to exist (as opposed to unwinding all remaining LIBOR-based contracts). For all LIBOR currencies, alternative RFRs are available and these RFRs can be used as a fallback rate for LIBOR-based instruments. Fallback solutions are needed for both derivative instruments and banking products. The smoothest way to assess the transition is to gradually reduce, where possible, the exposure to LIBORs before the end of 2021 and conclude more new businesses using alternative RFRs over time. This transition should be done in a very structured manner.
As key benchmark rates (IBORs) will be discontinued, the International Swaps and Derivatives Association (ISDA) is working on defining robust fallback arrangements upon cessation of the referenced benchmarks in derivative contracts. The fallback framework developed by ISDA, widely adopted by local NWGs, generally consists of (a) a fallback description and (b) an adjustment of the floating IBOR-based rate of the derivative to the relevant ‘adjusted’ RFR. These components of the fallback framework are explained in detail below:
Fallback description: An important consideration is that fallback arrangements defined by ISDA only apply to derivative instruments and are not necessarily appropriate for banking products (e.g. loans, mortgages) and other types of financial instruments (e.g. bonds, notes). The fallback description in the contract is a statement identifying the objective of the trigger that would activate the fallback. This can include cessation as well as pre-cessation triggers. A cessation trigger is an event that forces the permanent discontinuation of the LIBOR rate. A pre-cessation trigger relates to an event that leads the LIBOR to be not representative anymore and results in the contract moving to the alternative RFR prior to discontinuation.
Spread adjustment: Upon occurrence of the trigger, the floating rate of the derivative is amended to a fallback rate (i.e. per currency a predefined overnight RFR). For CHF LIBOR (unsecured), the predefined RFR is the risk-free (secured) SARON rate. Since IBOR are term rates, the move to an overnight rate then requires applying an adjustment to the relevant overnight rate such that it is comparable to IBOR. This is called the ‘adjusted RFR’. The adjusted RFR equals the overnight RFR (e.g. SARON) plus a spread adjustment. Moreover, the spread adjustment reflects the structural difference between LIBOR and the alternative RFR and includes premia for term, liquidity and credit risk. The spread adjustments are explained below in more detail:
- Term premium: This is the excess yield that market participants require for holding longer-dated instruments as opposed to rolling shorter-dated instruments (with similar risk). This premium reflects the amount market participants expect to be compensated for lending for longer periods.
- Liquidity and credit spread premium: This premium encompasses both liquidity and credit risk, which are intrinsic in the LIBOR (unsecured) rate. Liquidity risk reflects the ease at which banks can borrow in the money market from each other and instruments can be traded in the market. Credit risk relates to perceived default risk of the counterparty and consequently the impact on cost of funding.
The spread adjustment depends on the structure of the RFRs. Some of the alternative RFRs (e.g. SONIA and €STR) are based on unsecured markets, while others (e.g. SOFR and SARON) are based on secured markets. SARON is a risk-free rate derived from the Swiss Franc repo market. In contrast, the CHF LIBOR is an unsecured (interbank) lending rate, which includes a credit risk and liquidity premium and reflects fluctuations in supply and demand in the interbank lending market. Figure 1 illustrates the structural difference between CHF LIBOR and (compounded) SARON.
Figure 1: Illustration of structural difference between CHF LIBOR and SARON. In case of negative rates, the compounded SARON rate will be lower than the SARON (O/N) rate. When rates are positive, compounded SARON will exceed SARON (O/N).
The fallback rate will be calculated as a ‘compounded setting in arrears rate’. In this approach, the relevant RFR observed over the respective IBOR tenor is compounded daily during that period. The main advantage is that it is understandable and reflects actual daily movements in spot rates during the relevant period and is averaged (read: compounded) over that period such that it is less volatile than the spot overnight rate. Furthermore, this approach also mirrors the structure of overnight index swaps (OIS) that reference the RFRs.
ISDA provides guidance for the fallback transition. All actions aim to (a) eliminate or minimize value transfer when the fallback is triggered and (b) eliminate or minimize any potential for manipulation. Finally, the impact of market disruption, when a fallback is triggered, must be eliminated or mitigated. The ISDA consultation discussed three spread adjustment approaches:
- Forward approach: the spread adjustment is calculated based on the observed market prices for the forward spread between the LIBOR and the adjusted RFR at the time of the fallback is triggered. Upon the permanent discontinuation of LIBOR, the fallback consists of the adjusted RFR (published each day), plus a spread taken from the spread curve, which (a) specifies the spread to be applied for every future date and (b) is frozen at the point of trigger. Theoretically, this spread adjustment matches expected market (i.e. present-value neutral) pricing on the day before the fallback is triggered, therefore significant market value transfers on fallback date are (mostly) prevented. However, this approach is vulnerable to manipulations and distortions in the market.
- Historical mean (or median) approach: the spread adjustment is based on the mean (or median) difference between the LIBOR and the compounded RFR, calculated over a static lookback period (e.g. 5 years, 10 years) prior to the fallback trigger event. This spread adjustment is then used starting from the end of a 1-year transitional period after the fallback takes effect. During the transitional period, the spread to be used would be calculated using a linear interpolation between the LIBOR-adjusted RFR spread fixed at the time of the fallback and the mean (or median) historical spread that would apply after the end of the transitional period. This spread adjustment reflects (a) current market conditions at the time of the fallback takes effect and (b) captures tendency of interest rate to fluctuate around a long-term mean. The effect of market distortions and manipulations are reduced since the transitions is based on longer-term average market conditions. A drawback is that this approach is unlikely to be present-value neutral, since the historical spread is not consistent with market expectations (i.e. deviating from forward spreads).
- Spot-spread approach: the spread adjustment is based on the spot spread between the LIBOR and adjusted RFR on the day preceding the announcement triggering the fallback provision. A variation would be to use the average of daily spot spreads over a very short time period, e.g. number of days (like the historical mean approach). This approach is simple to implement, but unlikely to be present-value neutral on the fallback date, because it reflects current market conditions and not future market expectations.
An overwhelming majority (ca. 70%) of respondents of the consultations, preferred the historical mean (or median) approach. The reason is that this approach is simple, robust and resistant to market distortion and manipulation. Moreover, the Swiss NWG indicated that the spread adjustment using the median is preferred, since the median approach is more stable than the one calculated with the mean. Moreover, during the April meeting, the Alternative Reference Rates Committee (ARRC) announced the recommendation of a spread adjustment methodology for USD LIBOR cash products based on a historical median over a five-year lookback period of differences between USD LIBOR and SOFR.
Important is to differentiate between announcement and replacement date. The “announcement date” is the date on which the statement about the future discontinuity or non-representativeness of LIBOR is made and the “replacement date” is announced. This date triggers the spread adjustment calculation. Contracts will continue to refer the relevant IBOR until the replacement date. The “replacement date” is the date on which the LIBOR is effectively discontinued or no longer representative. Contracts which refer to the relevant IBOR will reference the fallback rate (combination of compounded RFR and spread adjustment set on the announcement date). Moreover, there are two parties that can trigger the end of LIBOR: (a) the ICE Benchmark Administration (IBA) by announcing a voluntary discontinuation for which at least one year of prior notice is necessary. (b) FCA by announcing the lost of representativeness which can be assessed through the exit of a panel bank or every two years.
Nevertheless, for the sake of simplicity and as long as it is in favor for the client, a direct replacement of the CHE LIBOR with the compounded SARON in cash product is accepted (i.e. the spread could be left out).
Empirical spread adjustment as fallback in Switzerland
Following the outcome of the ISDA consultation, an empirical analysis has been made of the historical spreads between SARON and CHF LIBOR in Switzerland. Based on a historical period of approximately 5 years, the spread adjustment has been estimated using the historical median approach. The historical development of the 1M compounded SARON and 1M CHF LIBOR, as well as the difference (spread) between the two, are shown in Figure 2 (left graph). During the past 4 to 5 years, the 1M CHF LIBOR was lower than the 1M compounded SARON, where the spread historically varied (mostly) between 0 and -15 basis points. The median spread over the past 5 years has been estimated at -5.5 basis points. Adding this median spread onto the 1M compounded SARON results in the estimated 1M adjusted SARON. This 1M adjusted SARON has been recalculated over the historical time horizon and compared to the 1M CHF LIBOR in Figure 2 (right graph).
Figure 2: The left graph shows the historical spread between 1M CHF LIBOR and 1M compounded SARON since beginning of 2016. The right graph shows the 1M compounded SARON adjusted by the median spread versus 1M CHF LIBOR. The historical 1M median spread adjustment is estimated at -5.5 bps.
Similar spread estimations have been made for the 3M CHF LIBOR and 6M CHF LIBOR. The historical median spread has been estimated at +0.1 basis points and +7.7 basis points for respectively 3M and 6M CHF LIBOR. For more details, see Figure 3 and Figure 4 in Appendix I.
The transition from IBOR to alternative reference rates affects all financial institutions from a wide operational perspective, including how contracts are written and priced, how risks are being managed, and how IT systems are operated. To address all these challenges prior to the end of 2021, banks need to dedicate time and resources to the IBOR transition. For this reason, it is important to develop a concrete and detailed action plan, that explains how the financial institution addresses the challenges. In the next installment, IBOR Reform in Switzerland – Part V, the Swiss NWG checklist and the Zanders IBOR Assessment will be explained in more detail.
For more information about the challenges and latest developments on SARON, please stay in touch with Zanders Switzerland.
Martijn Wycisk or Davide Mastromarco
Figure 3: The left graph shows the historical spread between 3M CHF LIBOR and 3M compounded SARON since beginning of 2016. The right graph shows the 3M compounded SARON adjusted by the median spread versus 3M CHF LIBOR. The historical 3M median spread adjustment is estimated at +0.1 basis points.
Figure 4: The left graph shows the historical spread between 6M CHF LIBOR and 6M compounded SARON since beginning of 2016. The right graph shows the 6M compounded SARON adjusted by the median spread versus 6M CHF LIBOR. The historical 6M median spread adjustment is estimated at +7.7 basis points.
The other articles on this subject:
Transition from CHF LIBOR to SARON, IBOR Reform in Switzerland, Part I
Calculation of compounded SARON, IBOR Reform in Switzerland, Part II
Compounded SARON and Swiss Market Development, IBOR Reform in Switzerland, Part III
 Mastromarco, D, Wycisk, M. Compounded SARON on the Swiss Market, IBOR Reform in Switzerland – Part III. April 2020.
 National Working Group on Swiss Franc Reference Rates. Discussion paper on SARON Floating Rate Notes. July 2019.
 National Working Group on Swiss Franc Reference Rates. Executive summary of the 12 November 2019 meeting of the National Working Group on Swiss Franc Reference Rates. Press release November 2019.
 National Working Group on Swiss Franc Reference Rates. Starter pack: LIBOR transition in Switzerland. December 2019.
 Financial Stability Board (FSB). Overnight Risk-Free Rates: A User’s Guide. June 2019.
 ISDA. Supplement number 60 to the 2006 ISDA Definitions. October 2019.
 ISDA. Interbank Offered Rate (IBOR) Fallbacks for 2006 ISDA Definitions. December 2019.
 National Working Group on Swiss Franc Reference Rates. Executive summary of the 7 May 2020 meeting of the National Working Group on Swiss Franc Reference Rates. Press release May 2020.
 ARRC. 04/2020. Responses to the ARRC Consultation on Spread Adjustment Methodologies for Fallbacks in Cash Products Referencing USD LIBOR.